Edward Hugh
Fernando, I really don't know how to convince you, but I really do suggest you look through the debates in the Latvia and Baltic blogs since late 2007, since we have been through all this there - in fact I have been arguing actually for devaluation there, but they insist on the very painful internal devaluation procedure. But just look how painful ... Read Moreit all is, and how, basically time has justified what I was arguing all along.

But why do you think the Irish are doing what they are doing. Do you think they are badly advised by the EU Commission and by the ECB who are financing the process? Are Spain's economists right, and everyone else wrong?

This is what they used to say in Estonia and Latvia, and just look where they are now.

The thing is that this is a worldwide crisis and there are some countries that are weaker than others. If the world crisis carry on it is possible that the meltdown happens for these countries (as it is happening now for the Baltics), among the weaker ones, Spain, On the contrary, if growth shows up in Germany and France, the Spanish trade balance will improve and there will be no meltdown. We are all in the same boat, some countries a little bit more drowned than others, but all half-way drowned.

Regarding the economists, either Spanish or from Brussels, they do not have a good record for forecasting the long term. It is very difficult. Politics and psychology play a big role in that.

Fernando, this is a complex situation. You are right it is a global financial and economic crisis, but what I do note is that in what you call the "weaker" countries there is a strong tendency to derive comfort from that fact, rather than look and see what it is exactly about the particular countries people live in that makes them weaker, and thus more vulnerable to the problem. That is people can use the fact that the crisis is global to avoid thinking about the actual reality that faces them. I am thinking especially here of a number of countries in Eastern Europe - not only the Baltics, but also Russia, Ukraine, Bulgaria, Romania, Hungary, Serbia and Croatia.

And (if we leave out Russia which is a special case due to the energy factor), do you know what all these countries had in common during the bubble years? They were all running large current account deficits, current account deficits which are now no longer sustainable.

Structurally such growth is now impossible, since as Paul Krugman pointed out, all the former CA surplus countries now need to export and run trade surpluses to grow, and it is not clear which countries can buy all the added output, when countries in general are still reducing imports, and certainly not about to open up deficits which would soak up the new surpluses.

The UK and the US do, however, have one advantage - they can issue debt in their own currency, and they can devalue, and that is the road these two countries are going down. But remember, the US and UK consumers will now play little part in facilitating headline growth in the global economy, since they will now be net savers.

Which brings us to Southern Europe. Italy is simply suffering from an ageing related slow death, and has a different problem set, but Portugal, Greece and Spain all had large CA deficits, and these are now closing. The thing is, these countries don't have their own currency - they have to issue debt in euros, and they can't simply fuel inflation (like they did in the past) since they can't print money, only the ECB can do that, and the ECB is a multi-national institution.

Now the ECB is facilitating all the liquidity you want, but it is SOOO important to understand this only aids liquidity, it does not resolve the solvency related issues (which the individulal countries have to do for themselves) and in fact only adds to the accumulated debt.

So Spain's external debt is rising at this moment, even as GDP is falling. Worse, nominal GDP (that is current price) is now falling faster than real (inflation adjusted) GDP so the value of the debt remains with the value it has, while GDP shrinks in proportion to it. I have been following this problem in Japan for the best part of a decade now.

So we are really caught on the horns of a dilema here, we have to deflate (willingly or unwillingly, the so called internal devaluation) but so long as we don't attract investment for new export industries and the rest of the global economy doesn't recover and some countries start to run significant deficits, then we are only goping to plumb the bottom.

In fact, you could think of the "L" shaped recovery like this, as a submarine with a damaged engine that simply sinks to the bottom of the ocean, and then, untill the parts arrive to repair the engine, the submarine has not the power to head back towards the surface.

But the thing is you are up against a clock, as the oxygen starts to run out (so yes, we are all in a kind of adventure movie right now). In the case of Southern Europe the oxygen is really the ability of the government to keep supporting the economy. As the deficits rise, and debt to GDP goes up, then the ability of the government to finance goes down, as does the willingness of the ECB to keep facilitating this finance. They are completely frustrated in Frankfurt, since they are keeping the economies of Greece, Spain and Portugal on life support.

I mean, lets not fool ourselves, the main reason those famous government boond "spreads" have tightened is due to the willingness of the ECB to discount the bonds which are first purchased by local financial entities and then passed on - a practice one of my Spanish friends calls "truco del almendro". Effectively the ECB is doing fiscal policy by buying a large part of the new debt - this is in fact Quantitative Easing via the back door. But they will not be willing to do this for very long, since they cannot keep accumulating Iriah, Austrian and Southern European bonds ad infinitum, as the Bank of Japan does with JGBs - the risk for the ECB of taking substantial capital losses if there is a sovereign debt problem (which there will be) in one of the member states simply grows by the day, and ultimately the German and French taxpayers will have to pay these losses, but they will be very reluctant to do so if people in the worst case countries have effectively done nothing for themselves

So, coming back to where we started, with growth in Germany and France. This is unlikely to be anything like as strong as you seem to be expecting. France will be better than Germany, but the German economy may well contract over 2009 more than the Spanish economy, and I expect Germany's problems (like Japan's) to continue well into 2010, simply because both these countries are now very high median age societies which are completely dependent on exports to grow - which means that now that the UK, US, Eastern and Southern Europe are no longer running deficits, Germany is very hard pressed to get the trade surplus she needs for headling GDP growth, which brings us back to Krugman's joke about which planet is going to do the importing?

Essentially, I am not a complete catastrophist, since I think there is a mid term solution out there - and it lies in the unwinding of the global demographic and wealth imbalances, and the economic development of a number of key emerging economies - in a way which was perhaps similar to the implementation of the Marshall Plan which is what effectively brought the first global depression to an end.

But I think we are still some years away from being able to get an agreement on such a programme - as you will have noted the G20 isn't really talking about this yet, but they will - and meantime we all have to stagger forward.

Well, I realise you most probably still won't be ready to agree with me, but at least you now have a fuller idea of my position. But tell me, is economics at all an empirical subject for you? That is, are you willing to change your mind at some point? And if so, what would lead you to change your mind?

I am clear what would change my mind, a return to positive GDP growth in Spain (ie over a number of quarters) and a steady trend reduction in seasonally adjusted unemployment even as the government deficit reduces, then I will accept, I have been wrong.

But I don't think we are going to see that. The government in Spain is already wobbling under the weight of the fiscal deficit, and they will now have to either ease back spending or raise taxes, either and both of which will only accelerate Spain's economic contraction.

So personally, my view is that the global financial and economic crisis is far from over. There is another stage to come, and the focus of the problem will be Southern and Eastern Europe.

Kierevelos said...

I think that Edward, indeed, does not see any hope in the final fate of the Spain Economy. Sometime ago he considered as likely that the ECB finally could have rescued us from the european oblivion by issuing some kind of European Bonuses and pumped into the spanish economic stream to put our end somewhen later off, but not honey, no money. There will be not any rescue from Europe, not even from Germany.

So, the only way out of this nightmare for Spain is getting out of the Euro. I think that Edward has also regarded this scenario as the most realistic, but he doesnt openly dare to say that, due to the fear that he might trigger some snow-ball doom with the echo of his words over the course of the spanish economy.

Edward Hugh said...
Kierevelos,

"So, the only way out of this nightmare for Spain is getting out of the Euro."

No, actually I don't think this. This is impossible, since the Germans would never permit it. The key here is the external debt. German banks hold a lot of this debt. Spain coming out of the euro would mean a huge devaluation and a large default, this would simply all get to be too much for German banks who are already struggling under losses from US sub-prime and East Europe. German pensions are obviously now not going to be what they were, in the longer term.

You are right, I earlier imagined they would try to resolve the issues by producing EU bonds, but this was evidently too complicated politically.

The ECB is lending over one year to the banks, and they are living off a sort of "carry" where they use the money - not to generate mortagages but - to buy government debt.

All of this works as long as it does, and as long as the ECB holds rates at one percent (or below), but if there really was a recovery in other parts of the eurozone (which I think there isn't really yet, but one day there will be) then, there would be big problems for Spain's banks, due to:

i) the maturity mismatch between loans at one year and government debt at say five years. They would have then to try and offload the debt rapidly, and this in istelf would send the spread shooting up.

ii) Spain's banks ahve also benefited from having euribor come down while they only do an annual "fixing" with mortgage holders. When this reverses the banks will have serious short term cahs flow problems.

Simply put, Spain can't afford to see a recovery in the rest of the eurozone first, and the rest of the eurozone can't afford to see Spain simply go to the dogs.

So everyone now has a large problem, which I imagine is concentrating the minds wonderfully in Madrid, Brussels, Berlin and Frankfurt.

9:01 AM

Latvia’s Agony Continues In The Second Quarter - With Little Relief In Sight
de A Fistful Of Euros » A Fistful Of Euros de Edward Hugh

Latvia’s economy shrank a revised 18.7 percent in the second quarter of 2009 over a year earlier in what was the second-steepest drop in the entire European Union (worsted only by Lithuania) according to detailed data released by the statistics office yesterday. The contraction, which is now the largest since quarterly records began in 1995, was revised down from a preliminary estimate of a 19.6 percent annual drop. And Latvia’s problem can easily be seen in the above charts which show the most recent movement in exports, and quarterly data for constant price imports and exports. The Latvian economy grew driven by domestic consumption and increased borrowing during 2006 and most of 2007, but then the country ran out of extra sources of cash, and so imports slumped, followed by exports as the global economy entered crisis. Now its time to pay back, which means the lines we see in 2006 and 2007 will now need to be repeated, only this time with exports on the top and imports below. Of course, really doing this will only be possible once the global economy recovers. But the key question is, will Latvian export capacity be ready when that critical moment comes, or will Latvia’s agony continue, stuck in a horrid “L” shaped “non-recovery”? The most recent data on foreign trade, which saw exports fall and the trade deficit once more widen suggest that the latter danger is far from being a mere theoretical one.

And I am not the only one to be raising it, since according to the latest report out from Nordea Bank, Estonia, Latvia and Lithuania, may well suffer deeper economic contractions than previously estimated as government austerity measures simply serves to sap domestic demand while export growth remains muted.

So well done Nordea! But please permit me to say that this discovery does come as a bit rich from analysts who have persistently remained in denial that the key to Latvia’s recovery was a substantial reduction in the price level in order to facilitate exports (on my view better achieved by formal devaluation, but by the express desire of the elected political leaders of the Latvian people now being carried out via a convoluted and painful process known as “internal devlauation”).

Still, it is interesting to see mainstream analysts starting to question the current orthodoxy that fiscal prudency will (due to the impact on investor confidence) lead to recovery in Eastern Europe, while here in the West our leaders have just re-affirmed the need to maintain fiscal stimulus, given the fragility of even those earliest signs of recovery.

In the following monthly report I will examine just what evidence there is for the idea that Latvia’s economy has actually bottomed out.

The Fall In GDP Continues


Latvia’s economy shrank an annual 18.7 percent last quarter, following a drop in gross domestic product of 18 percent in the first quarter. The charge downwards was lead by a decrease in private final consumption which fell an annual 23.21% (year on year - see chart). Government final consumption dropped bya mere 6.9%, but expenditure on gross capital formation (which includes the critical investment item) crashed by 38.1% - with construction (which forms part) down 29.5% (see chart below). Goods exports (63.6% of total exports) was down by 19.1% and the export of services by 15.7%. The slump in imports was, of course) even worse with the volume of goods imports (78.8% of total imports) down 39.4%, and the volume of services imports by 38.2%.

But Slows On A Quarterly Basis

Quarter on quarter, however, the rate of contraction did slow slowed substantially, from an 11% rate in the first quarter to a 1.6% rate in the second quarter. But even though the rate of contraction is now much, much slower, the economy is still contracting, so I think it is not quite accurate to say we have hit bottom yet. And hitting bottom is not the same as recovering, since there is unlikely to be any rapid bounce back, and any “recovery” is likely to have an “L” shape with a slight upward slope.

Meanwhile, and hardly surprisingly, during the month Latvia’s credit rating was lowered by Standard & Poor’s, with the long-term foreign currency rating being lowered to BB, two notches below investment grade, from BB+, with a negative outlook. According to S&P’s:

“The rating action reflects our view of the political and economic challenges as a result of rapidly contracting nominal and real incomes and the associated pressures on public finances, as the country struggles to improve its growth prospects while maintaining a fixed exchange rate regime…..The outlook for growth beyond that remains highly uncertain, not least due to highly leveraged household balance sheets.”

S&P’s estimate that Latvia’s general government debt, which stood at 19 percent of GDP last year, will grow to over 80 percent in 2011, an estime which is broadly in line with current EU Comission forecasts.

The International Monetary Fund also agreed on August 27 to disburse the second installment (of around 200 million euros) of the 1.7 billion-euro credit line approved last December. The decision followed a long period of uncretainty. Latvia’s government is trying to cut spending/or raise revenue by 500 million lati ($1 billion) a year between now and 2012, in a bid to get the budget deficit below 3 percent of GDP as part of an attempt to meet euro adoption criteria.

The IMF said in their statement that the program had been adjusted to reflect:

- a significant increase in the program’s fiscal deficit ceiling in 2009 (up to
13 percent of GDP, compared with 5 percent in the original program) to avoid
measures that would harm the most vulnerable, and

- an allowance of 1
percent of GDP in additional resources for social safety nets.

The statement which Moody’s following the IMF decision asserting that Latvia’s Baa3 government bond rating - the lowest investment grade, - was being kept at stable was hardly surprising, although the justification they gave - that the bond issuance was supported by “significant, extraordinary fiscal assistance” from international lenders - surely was significant, and very much to the point. The EU Commission and the IMF are now guaranteeing and in order to do this have effectively assumed sovereign responsibility fo the country (see Appendix below).

Moody’s were also a little more optimistic than S&Ps on government debt, since they estimated it would only rise to about 60 percent of gross domestic product in 2010 and fluctuate from about 60 percent to 65 percent over the medium term. I think this is too optimistic, basically for the sort of reasons S&Ps are giving. On the other hand they did also state that a currency devaluation, while not being their central scenario, “was a clear risk, along with additional problems in the banking sector”.

Little Sign Of Any Recovery In Main Indicators

If we now come to the future, we have to note there is little hard evidence at this point for any real recovery - nor should we expect to see any. Industrial output is still falling, and was down 1.4 percent in July over June, and 17.7% year-on-year (over July 2008). This compared with a 18.5% annual fall in the previous month.

Latvia’s industrial output started falling in February 2008, and has now fallen 22.4% from it peak.

Retail sales were down 1% in July over June, and 29.5% over July 2008.

Retail sales have now been falling since April 2008, and are now 31.18% below their peak.

The Trade Defict Widens in July As Exports Drop Back

Latvia’s July trade deficit was 95.2 million Lati up from 67 million Lati in June. This was the first increase since December 2008. Latvian foreign trade turnover came in at 613.3 mln lats in July, down by 3.8% or 24.5 mln lats in current price terms than a month earlier and and down by 41.1% over July last year.

In the January – July 2009 period foreign trade turnover was 4517.6 mln lats – down by 36.1% or 2547.5 mln lats over the same period in 2008.

In July exports were down by 32.6% over July 2008 and imports down 46%. Over January to July exports were down by 27.2% or 705.4 mln lats, while imports were down by 41.2% or 1842.1 mln lats over the same period a year ago.

Unemployment Continues To Rise, And As It Does Bad Loans Pile Up In the Banking Sector

Latvia’s unemployment rate hit 17.4% in July according to Eurostat data, and again this was the second highest level in the European Union (after Spain). Naturally with unemployment rising to such levels the number of distressed loans continues to rise and bad debt provisions in the banking sector wnet up again - to 6.6 percent of the total credit portfolio in July from 6.1 percent the month before, according to credit supervisor FKTK.

The FKTK also said in a statement that bank losses by the end of the first seven months had hit 400 million lats ($817.6 million), up from 346.8 million lats at the end of the first half.

Lending was again down, and the total credit portfolio fell by 0.7 percent in July. The level of debts with delayed payments of more than 90 days rose to 13 percent of the credit portfolio from 12 percent at the end of June.

What About The Internal Devaluation, Is It Working?

Well, prices have started falling, and the consumer price level was down in August by 1.0% compared to July. The average prices of goods fell by 1.3%, and of services by 0.4%. But if we compared to August 2008 we find that consumer prices (as measured on the Latvian national index) have incredibly still increased by 1.8% (down admitdely from the 2.5% rate of increase in July), which leads me to ask, given the pain that all of this is evidently causing, are prices still falling too little and too late to do any real good.

The central bank seems to think the process is working, since they point out on their website that the real effective exchange rate of the lat, which is one measure of the price competitiveness of Latvian goods versus those of the country’s major trading partners, improved between April and July, marking the first four-month gain since the beginning of 2005. We need to remember howvere that the REER index showed prices developing far faster than trading partners all the way from 2006 through to April 2009 (see comparative chart with Finland below) so there really is a long long way back down to go. And if we look at the chart immmediately below, we will see that while the gap is closing Latvian prices are still in a worse position in August 2009 (as compared to other Eurozone countries) than they were in August 2008 - that is over the last year as a whole the position has even deteriorated.


A similar picture can be found in producer (factory gate) prices, which have only recently moved into negative territory on an annual basis. To get a comparison, German producer prices were down 7.8% year on year in July, while

In fact, while export prices are dropping substantially, import prices are also falling (see chart), and thus the real rate of price correction is still quite small.

I therefore contend that this weeks statement from Unicredit Group Chief Economist Marco Annunziata to the effect that, “For the region as a whole and for Latvia, we have gone through the worst,” is way too premature. Conditions are not improving, and as Moody’s suggested pressures in the banking system are still building up. It is an open empirical question at this point whether we have the worst behind us. Even over a longer term horizon it is hard to see the grounds for optimism, since there are certainly no “green sprouts” to be seen on the new babies front, with year on year three month moving average being stuck around the 8% drop level. This depression is going to cast a long shadow over the future of the Latvian people, let’s hope for everyone’s sake that all those responsible (the government, the IMF, and the EU Commission) are fully aware of their hsitoric responsibilities here.

Appendix: IMF and EU Conditions from the respective Letters of Intent.

According to the letter of intent signed by the Latvian Government, The Central Bank and the IMF, a number of new reporting obligations were agreed to. These include:

* Consolidated central (basic and special budgets), local and general government operations based on the IMF fiscal template
* Detailed information on revenues from EU funds at the general government level, and EU-related spending by the central government, including transfers to local governments for EU-related spending
* Consolidated central and general government bank restructuring operations
* Privatization receipts received by the general government budget (in lats and foreign exchange, and payments in governments bonds)
* Information on debt stocks and flows, domestic and external (concessional and non concessional), by currency, and guarantees issued by the (i) consolidated central, local and general governments and (ii) public enterprises (including the Latvian guarantee agency and
the Rural guarantee fund), including amounts and beneficiaries
* Information on new contingent liabilities, domestic and external, of the consolidated central, local and general governments
* Data on general government arrears, including to suppliers
* Data on operations of extrabudgetary funds
* Data on the stock of the general government system external arrears
* Balance sheet of the BoL, including (at actual exchange rate) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Balance sheet of the BoL (in program and actual exchange rates) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Consolidated accounts of the commercial banks
* Monetary survey
* Currency operations, including government foreign receipts and payments and breakdown of interbank market operations by currencies (interventions)
* Aggregated data on free collateral—available, unpledged collateral held at the Bank of Latvia
* Daily data with banks’ current accounts, minimum reserve requirements, stock of repos and fx swaps
* Foreign exchange rate data
* Volume of foreign exchange lats trades
* Projections for external payments of the banking sector falling due in the next four quarters, interest and amortization (for medium and long-term loans)
* Projections for external payments of the corporate sector falling due in the next four quarters interest and amortization (for medium and long-term loans)
* The stock of external debt for both public and private sector

The Letter of Intent follows the earlier signing of a Supplementary Memorandum of Understanding between the Latvian government and the European Union. The terms of this understanding contained the following Monitoring and Reporting protocols.

Monitoring fiscal developments

• Monthly revenue and expenditure break-down of social budget, including data on social
benefits’ hand-outs (unemployment, family, etc).
• Monthly state basic budget expenditure breakdown per type of expenditure for each
ministry or other relevant budget entity.
• Monthly revenue and expenditure break-down of local governments, including data on
GMI hand-outs and other benefits included in category “other social support”.
• Monthly information on debt stocks and flows and guarantees given on new debt,
contracted by the (i) consolidated central, local and general governments and (ii) public
enterprises.
• Monthly data on new contingent liabilities of the consolidated central, local and general
governments.
• Monthly data on state budget loans and PPP projects.
• Monthly information on central government (i.e., ministries and agencies) and state
owned companies’ staff and remuneration levels, institution-by-institution, showing last
months’/years’ trends.
• Monthly data on general government arrears, including to suppliers.
• Bi-weekly Treasury cash-flow assessment of central government financing needs.

Monitoring financial developments

• Monthly statements of the operations on the special account.
• Monthly report on the amount of mortgage loans converted from EUR to LVL.
• Monthly report on outstanding loans split by currency and detailed to households
(housing, consumer, other) and non-financial corporations (by sector).
• Notify DG ECFIN whenever there is a consultation process with DG COMP related to
financial sector stabilization (i.e., Parex).
• Monthly report on banking sector stabilization measures.

Monitoring structural reforms

• Monthly data on budget allocations to and appropriations of line ministries for financing
of EU Structural funds and Cohesion fund projects (including which programming
period they are related to).
• Monthly data on the amounts disbursed to final beneficiaries for project
implementation, by ministry and by EU Structural funds and Cohesion fund projects
(including which programming period they are related to).
• Monthly data on the amounts spent by state budget financed entities as final
beneficiaries on EU Structural funds and Cohesion fund project implementation, by
ministry and by EU fund (including which programming period they are related to).
• Monthly financial reports on reaching the Structural Funds and Cohesion Fund
expenditure targets by the Managing Authority.
• Quarterly qualitative assessment reports on reaching the Structural Funds and Cohesion
Fund expenditure targets by the Managing Authority.
• Quarterly assessment of policy options taken by the government regarding poverty,
health and pensions.

Hi LA, I can't help really clear up your mystery, we will just have to wait and see. But what the whole debate does reveal is just how little idea everyone has of what "internal devaluation" might look like in the modern world.

This is astonishing since the process will be the key to the future and survival of the entire eurozone. Of course, people had fooled themselves with a simple and simplistic idea of "convergence theory", but still.

The techniques really are very primitive. I'm sure they are attempting to drive down salaries in the public sector, but if the proportions are as high as you suggest, then they will simply drive educated people out of the country, and will not at all augment the supply of potential factory workers, which is how the thing should work.... Read More

The idea is to get the general price level down by reducing wages in the public sector, and letting unemployment push them down in the private sector.

Edward, really scary to think that not well understood how to perform a internal devaluation. It sounds like there's little chance of success in Spain.

Juan Carlos, the road ahead in Spain is evidently difficult, but I never give up on a battle before it even gets started. This is one we have to win, hard as it will be, for everyone's sake, and that of our children, and our children's children. Remember, the losses being incurred in Spain are effectively pensioners for Germans from 2015 to 2020. No one will escape unscathed here.

Edward, I honestly do not see in Spain the unions willingly cooperate in the process of internal devaluation.
The operation of the market in Spain is very flawed, with many oligopolies and captive markets, and very little commercial culture.
The aggregate supply is very inelastic in Spain, with very low slope. If a certain elasticity of aggregate supply can not see that to succeed a process of internal devaluation.

I can't say that you are totally wrong Juan Carlos, but I can see the consequences of you being right - Spain will be the next Lehman Brothers, and will plunge the whole global financial system into chaos again. Spain is the trigger than can ignite round two, if the National Bank of China doesn't get there first that is.